The Federal Reserve's Balance Sheet: A Primer and Projections

Finance and Economics Discussion SeriesDivisions of Research & Statistics and Monetary Affairs

Federal Reserve Board, Washington, D.C.

The Federal Reserve’s Balance Sheet: A Primer and Projections

Seth B. Carpenter, Jane E. Ihrig, Elizabeth C. Klee, AlexanderH. Boote, and Daniel W. Quinn

2012-56

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminarymaterials circulated to stimulate discussion and critical comment. The analysis and conclusions set forthare those of the authors and do not indicate concurrence by other members of the research staff or theBoard of Governors. References in publications to the Finance and Economics Discussion Series (other thanacknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

The Federal Reserve’s Balance Sheet

A primer and projections

Seth Carpenter, Jane Ihrig, Elizabeth Klee, Daniel Quinn, and Alexander Boote*

August 2012

Abstract

Over the past few years, the Federal Reserve’s use of unconventional monetary policy tools has

led it to hold a large portfolio of securities. The securities holdings in excess of historical norms

have been shown to be putting downward pressure on longer‐term interest rates. One

question asked is how long this unusual amount of monetary policy accommodation will be in

place. Here we provide projections of the evolution of the Federal Reserve’s balance sheet that

are consistent with public economic forecasts and announced Federal Open Market Committee

policy principles to help answer this question. We begin with a primer on the Federal Reserve’s

balance sheet. Then, with the foundational concepts in place, we present a framework for

projecting Federal Reserve assets and liabilities through time. In the projections, the Federal

Reserve’s balance sheet remains large by historical standards for several years. Our baseline

projection suggests that market participants likely do not expect the Federal Reserve’s portfolio

to return to a more normal size until August 2017, and its composition to return to normal until

September 2018. Overall, this suggests that market participants believe that unconventional

monetary policy will be in place for some time, likely depressing longer‐term interest rates for a

number of years.

*The authors are staff economists and research assistants in the Division of Monetary Affairs, Board of Governors

of the Federal Reserve System, Washington, D.C. 20551 U.S.A. We thank James Clouse, Bill English, Michelle Ezer, Don Hammond, Lawrence Mize, Julie Remache, Viktors Stebunovs, Lisa Stowe, Jeff Moore, Ari Morse, and Brett Schulte for thoughtful discussions and assistance. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.

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1 Introduction

In response to the financial crisis that began in 2007 and the subsequent recession, the Federal

Reserve employed a variety of nontraditional monetary policy tools. The use of these tools has

had a significant effect on the Federal Reserve’s balance sheet.1 Both the size and the

composition of the balance sheet have changed noticeably. As shown in Figure 1, through

2007, the assets of the Federal Reserve (reported above the horizontal axis) comprised mainly

Treasury securities. The single largest liability item (reported below the horizontal axis) was

Federal Reserve notes – that is, currency. Prior to the financial crisis, the Federal Reserve’s

balance sheet grew at a fairly moderate pace, with the Open Market Desk (Desk) at the Federal

Reserve Bank of New York purchasing additional Treasury securities roughly on pace with the

expansion of currency and Federal Reserve Bank capital.

At the start of the financial crisis, the Federal Reserve’s balance sheet began to expand at a

faster pace largely because of an increase of lending through the various liquidity and credit

facilities that were established at that time.2 These extensions of credit expanded the asset

side of the balance sheet, while a substantial portion of the matching increase on the liability

side of the balance sheet showed up in reserve balances.3 As these liquidity facilities began to

wind down, the Federal Reserve’s large‐scale asset purchase programs started to ramp up. The

Federal Reserve’s System Open Market Account (SOMA) portfolio—that is, its holdings of

securities––more than tripled from 2008 to today, and in June 2012 exceeded $2.6 trillion.

The SOMA value of $2.6 trillion is nearly $1.5 trillion above the current value of currency and

capital. The value of currency and capital, plus some level of reserve balances necessary for the

conduct of monetary policy would essentially reflect the normal size of the balance sheet

without the large amount of unconventional monetary policy accommodation currently in

1 The Federal Reserve’s balance sheet is published each Thursday in the H.4.1 statistical release, available at http://www.federalreserve.gov/releases/h41/. 2 For a discussion of the Federal Reserve’s credit and liquidity facilities, see http://www.federalreserve.gov/monetarypolicy/bst.htm. 3 Throughout this paper the phrase “reserve balances” will be used to denote deposits of depository institutions that are not in term deposits. This measure is reported in tables 8 and 9 of the H.4.1 statistical release as “Deposits, Other deposits held by depository institutions.” This concept is slightly distinct from the concept of reserve balances reported in table 1 of the release. That concept excludes, among other items, contractual clearing balances.

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place. These excess holdings of securities by the Federal Reserve have reduced private sector

holdings of these securities, and have put downward pressure on longer‐term interest rates.4

Having a projection of the balance sheet that is consistent with Federal Open Market

Committee (FOMC) guidance and public economic forecasts provides some guidance on how

market participants likely anticipate monetary policy accommodation to evolve. Studies that

aim to quantify the contemporaneous and expected future interest rate effects of the Federal

Reserve’s unconventional monetary policy can use these projections as an input in their

analysis.5

The Committee’s recent statements about the outlook for monetary policy and its discussion in

the minutes of the June 2011 FOMC meeting on “exit principles” suggest that the balance sheet

could remain large by historical standards for some time. This paper describes a framework for

constructing projections of the Federal Reserve’s balance sheet. These projections are not

forecasts. As will become clear, the projections depend critically on a whole host of

assumptions about future monetary policy decisions, financial market developments, and other

issues. Based on assumptions and projections of each of those factors, one can infer an implied

path for the balance sheet. These projections illustrate how the various factors that affect the

balance sheet of the Federal Reserve do so dynamically and allow for the analysis of alternative

scenarios. In this paper, we base our modeling on three key inputs. First, we start with the

Federal Reserve’s balance sheet as of May 30, 2012. Second, we interpret the minutes of the

June 2011 FOMC meeting to put some structure on a plausible exit strategy that removes

monetary policy accommodation. Finally, we rely on the June 2012 Blue Chip Economic

Indicators forecast for nominal GDP growth and interest rates. The Blue Chip Economic

Indicators is a consensus forecast based on a survey of professional forecasters; we use the

mean of the forecast for our selected economic variables. Importantly, we use the projection

for the federal funds rate to identify the timing of the first expected increase in the federal

4 See Yellen (2012) for more discussion of how the Federal Reserve’s balance sheet operations have had substantial effects on longer‐term Treasury yields, principally by reducing term premiums on longer‐dated Treasury securities. 5 See Ihrig et al. (2012) for a study that provides an estimate of the current and future expected path of the 10‐year term premium associated with the Federal Reserve’s unconventional monetary policy that is consistent with the balance sheet projections provided in this paper.

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funds rate, and we assume that the various elements of the exit strategy are tied to that timing.

All of these inputs are publicly available and in no way represent a forecast from the Federal

Reserve or its staff. To illustrate the dependence of the projections to the assumptions, we

perform a series of alternative simulations.

Key findings using the baseline assumptions noted above are the following. First, the

projections yield a Federal Reserve balance sheet that remains large by historical standards for

a number of years. In particular, the SOMA portfolio contracts at only a slow pace through the

medium term, reflecting the fact that the FOMC has stated that it anticipates that conditions

will warrant keeping the federal funds rate at exceptionally low levels at least through late

2014. Moreover the maturity extension program is reducing the holdings of shorter‐dated

Treasury securities in the portfolio to about zero, implying that there will be little passive

shrinking in the holdings of Treasury securities when the reinvestment policy is ended. Under

these projections, the SOMA portfolio does not return to a more normal size until mid‐ 2017,

and its composition does not return to normal until 2018. If these projections underlie the

beliefs of market participants, the implication is that the SOMA portfolio holdings should

continue to put downward pressure on longer‐term interest rates for a number of years.

The paper is organized as follows. Section 2 provides a primer on the Federal Reserve’s balance

sheet and accounting. Section 3 outlines the assumptions used as inputs to the projections of

the balance sheet. The balance sheet projections are discussed in Section 4. Section 5

concludes. Two appendixes are also included. Appendix 1 provides more detail on the

assumptions underlying the projections. Appendix 2 describes the method used to derive

projections of coupons on future purchases of SOMA securities.

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2 Background and historical perspective

2.1 The Federal Reserve’s balance sheet

Our discussion of the Federal Reserve’s balance sheet will refer to the consolidated balance

sheets of the 12 individual Reserve Bank balance sheets.6 In reality, the accounting that will be

discussed below is done at the Reserve Bank level; however, for simplicity, we focus on the

Federal Reserve System’s aggregate balance sheet.

Like any balance sheet, the Federal Reserve has assets on one side of the balance sheet, which

must equal liabilities plus capital on the other side. As shown in Table 1, at the end of 2006,

total assets of the Federal Reserve were $875 billion, with the single largest asset item being

the SOMA portfolio, at about $780 billion. Prior to the financial crisis, the domestic SOMA

portfolio comprised only Treasury securities, of which roughly one‐third were Treasury bills and

two‐thirds were Treasury coupon securities.7 On the other side of the balance sheet, the

largest liability item was paper currency, or Federal Reserve Notes (FR Notes), at about $785

billion. Federal Reserve capital consists of two components, capital paid in and surplus. 8 By

statute, member banks must subscribe to Federal Reserve Bank capital in an amount of 6

percent of each member bank’s capital and surplus, half of which is paid in (this portion is

referred to as capital paid in) and the other half is subject to call by the Board of Governors.

When a member's capital or surplus changes, its holdings of Reserve Bank stock must be

adjusted accordingly. Reserve Bank stock is quite different from stock in a private company and

does not confer all of the controls in the way that equity in private firms does. Surplus capital is

essentially retained earnings, and is equated to capital paid in.

6 The Board of Governors does not hold assets and liabilities in the same way that the Reserve Banks do. Section 10 of the Federal Reserve Act authorizes the Board to levy semiannually upon the Reserve Banks, in proportion to their capital stock and surplus, an assessment sufficient to pay its estimated expenses for the half of the year succeeding the levying of such assessment, together with any deficit carried forward from the preceding half year. 7 It is worth noting that there is a common misperception that the Federal Reserve only held Treasury bills prior to the large‐scale asset purchases. 8 See the Financial Accounting Manual for Federal Reserve Banks, which reports the accounting standards that should be followed by the Federal Reserve Banks at

www.federalreserve.gov/monetarypolicy/files/bstfinaccountingmanual.pdf, page I‐68.

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With the lending that took place during the financial crisis, for a time, lending of various sorts

surpassed the size of the SOMA portfolio. As of May 30, 2012, the SOMA portfolio was again

the largest asset item, but it had grown to over $2.6 trillion because of the asset purchase

programs. On the liability side of the balance sheet, FR Notes, at about $1.1 trillion, were no

longer the largest liability item. Instead, as the FOMC increased its asset purchases, reserve

balances increased correspondingly to a level about $1.5 trillion.

Table 1: Federal Reserve's Balance Sheet, end‐2006 and present

Source: H.4.1 Statistical Release

The next few subsections review the key components of the Federal Reserve’s balance sheet

and how they have changed.9

2.1.1 The SOMA portfolio: Composition, size, and maturity structure

Over most of the post‐war period, the SOMA portfolio was the largest asset item on the Federal

Reserve’s balance sheet.10 During that time, the SOMA portfolio essentially held Treasury

securities; however, the portfolio has held other types of securities in its portfolio over its

history.11 For example, from 1971 to 1981, the Federal Reserve purchased limited quantities of

agency securities; the last of these securities matured in the early 2000s, and no more were

purchased until 2008.12

9 For a description of additional components of the balance sheet, see the interactive guides to the H.4.1 tables at http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm, or the Financial Accounting Manual at http://www.federalreserve.gov/monetarypolicy/files/bstfinaccountingmanual.pdf. 10 For a description of the Federal Reserve’s balance sheet prior to World War II, see Banking and Monetary Statistics, 1914‐1941 (1943). 11 Refer to Edwards (1997). 12 Refer to Meltzer (2010).

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Historically, the size of the SOMA portfolio–and the balance sheet more generally—reflected

growth in FR Notes and Reserve Bank capital. When currency is put into circulation, it is

shipped to a depository institution and that institution’s account at the Federal Reserve is

debited by an equivalent amount. Because currency outstanding tends to trend upward, over

time currency growth would tend to reduce the amount of reserve balances in the banking

system. The Federal Reserve would purchase securities in open market operations to offset this

drain of reserves. On net, therefore, the growth rate of currency tended to drive the size of the

balance sheet. Similarly, when a depository institution subscribes to a larger amount of Federal

Reserve capital or the Federal Reserve adds to its surplus account, the result would be—all else

equal—a reduction in reserve balances. As a result, the SOMA portfolio must increase to offset

these increases as well, creating a larger balance sheet overall.

This historical pattern is illustrated in Figure 2. As can be seen, through 2007, both the SOMA

portfolio and currency and capital trended upward together. When the LSAPs began in late

2008 and early 2009, and continuing through the second round of purchases in 2010, the SOMA

portfolio increased markedly and at a rate that far outpaced the growth of currency and capital.

The expansion of the SOMA portfolio at that point was reflected in reserve balances.

The SOMA portfolio has a range of maturities of Treasury securities in its holdings.13

Historically, the Desk tended to purchase securities across the entire yield curve to avoid

distorting the yield curve. As shown in Figure 3, the weighted‐average maturity of Treasury

coupon securities in the SOMA portfolio stayed around three to four years. After the start of

the financial crisis, the maturity of Treasury coupon securities in the SOMA portfolio lengthened

notably, reflecting the runoff in bills to sterilize the credit and liquidity programs in 2008 and

the purchase of longer‐dated securities.

2.1.2 Premiums and discounts

Federal Reserve accounting records all domestic securities holdings at face value, rather than at

market value. Except for the rollover of maturing Treasury securities, new purchases of

13 In the weekly H.4.1 statistical release, in addition to the Federal Reserve’s balance sheet, the maturity distribution of asset holdings is also published.

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securities are conducted in the open market at market prices. If a security is purchased for

more than its face value, the difference between the purchase price and the face value—the

premium on that security—is recorded separately as an asset on the balance sheet. Likewise, if

a security is purchased for less than its face value, the difference between the purchase price

and the face value—the discount on that security—is recorded as a liability on the balance

sheet. Reserve balances increase by the purchase price of the security, that is, the face value

plus the net premium (premiums net of discounts). At maturity of the security, the Federal

Reserve will only receive the face value, so the premiums and discounts must be amortized

over the remaining term of the security. U.S. Treasury securities and agency debt securities

held by the Federal Reserve Banks are amortized linearly over the remaining term of the

security. In the accounting treatment of agency MBS premiums, the amortization schedule for

MBS is based on an effective yield calculation, which results in a constant rate of return during

the term of the security. In the analysis that follows, however, we simplify this assumption and

implement agency MBS amortization using the path of anticipated paydowns of agency MBS.

As of year‐end 2011, there were $88 billion in unamortized premiums and $1 billion in

discounts associated with holdings of Treasury securities and $12 billion in unamortized

premiums and $1 billion in discounts associated with holdings of agency MBS.14

2.1.3 Lending

Since its inception, the Federal Reserve has had the authority to lend to depository institutions.

Prior to the financial crisis, however, borrowing from the Federal Reserve tended to be quite

small, typically less than a couple hundred million dollars outstanding per day. During the

financial crisis, lending by the Reserve Banks grew significantly, at one point exceeding $1

trillion outstanding.15 Lending by the Federal Reserve increases reserve balances, all else equal,

because in lending to a depository institution, the Reserve Bank directly credits that

institution’s reserve account. As a result, reserve balances rose as lending increased during the

14 Refer to the Combined Financial Statement of the Federal Reserve System, available at http://www.federalreserve.gov/monetarypolicy/bst_fedfinancials.htm. 15 Included in this number are primary, secondary and seasonal loans; term auction credit; the primary dealer and other broker‐dealer credit, credit extended to AIG, net portfolio holdings of Commercial Paper Funding Facility, and the outstanding principal amount of loans extended by the Federal Reserve Bank of New York to Maiden Lane, Maiden Lane II, and Maiden Lane III.

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financial crisis. The loan to the institution is the corresponding asset on the Federal Reserve’s

balance sheet.

2.1.4 Deposits of depository institutions and reverse repurchase agreements

Deposits of depository institutions include balances at the Federal Reserve of all depository

institutions that are used to satisfy reserve requirements and balances held in excess of balance

requirements, as well as service‐related deposits. Deposits of depository institutions grew

dramatically through the crisis, and are currently quite elevated by historical standards. When

we refer to “reserve balances,” we are using the “deposits of depository institutions” concept.

These deposits represent funds that depository institutions own—they are a liability of the

Reserve Bank, but an asset of the depository institution. These funds are also used for payment

system settlement—for example, a payment from one bank to another (or from one bank’s

customer to the customer of a different bank) typically results in a debit to the paying bank’s

account and a credit to the receiving bank’s account. Lending of reserve balances and payment

activity result only in a movement of reserve balances from one depository institution’s account

at the Federal Reserve to another institution’s account; the aggregate quantity is unchanged.

2.1.5 Reverse repurchase agreements

The Federal Reserve conducts reverse repurchase agreements (reverse repos, or RRPs) by

selling securities to counterparties who sell the securities back to the Federal Reserve on a

stated future date. Currently, the largest portion of outstanding reverse repos is with foreign

central banks that hold dollars in their accounts at the Federal Reserve Bank of New York.

Known as the “foreign RP pool,” as of end‐May 2012, there was a little less than $100 billion in

foreign RP pool transactions outstanding on the Federal Reserve’s balance sheet.

In addition to the foreign RP pool, before the financial crisis, the Federal Reserve occasionally

engaged in reverse repos with primary dealers to drain reserve balances. These transactions

are conceptually distinct from the service provided by the foreign repo pool; in particular, they

are intended to be part of open market operations and therefore part of the conduct of

monetary policy. Since late 2009, the Federal Reserve Bank of New York has taken steps to

expand the types of counterparties for reverse repos to include entities other than primary

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dealers, in order to prepare for the potential need to conduct large‐scale reverse repurchase

agreement transactions.

2.1.6 Federal Reserve Notes

Federal Reserve notes, or currency, are a liability of the Federal Reserve. As a practical matter,

the quantity of currency outstanding is not determined by the Federal Reserve. Instead, when

a depository institution wants to hold currency in its vault or automatic teller machines in order

to meet customer needs, it requests a shipment from its Federal Reserve Bank. When that

shipment is made, the depository institution’s reserve account at the Reserve Bank is debited

by the amount of the currency shipment. One important source of demand for U.S. currency is

from overseas. Although it is impossible to know with certainty what portion of currency

outstanding is outside of the United States, estimates suggest that the fraction is one half or

more.16 Prior to the financial crisis, currency was the largest liability item on the Federal

Reserve’s balance sheet.

2.1.7 Capital paidin, surplus, and interest on Federal Reserve notes due to U.S.

Treasury

The capital of the Reserve Banks is different than the capital of other institutions. It does not

represent controlling ownership as it would for a private‐sector firm. Ownership of the stock is

required by law, the Reserve Banks are not operated for profit, and the stock may not be sold,

traded, or pledged as security for a loan. As stipulated in Section 5 of the Federal Reserve Act,

each member bank of a Reserve Bank is required to subscribe to the capital of its district

Reserve Bank in an amount equal to 6 percent of its own capital stock and surplus. Of this

amount, half must be paid to the Federal Reserve Banks and half remains subject to call by the

Board of Governors. This capital paid in is a required assessment on the member banks and its

size changes directly with the capital of the member banks. Also stipulated by law is that

dividends are paid at a rate of 6 percent per year. Over the past decade, reflecting increases in

capital at member banks, reserve bank capital has grown at an average rate of about 15

percent per year. In addition, Reserve Banks have surplus capital, which reflects withheld

16 Refer to Judson and Porter (1996).

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earnings, and Federal Reserve accounting policies stipulate that the Reserve Banks withhold

earnings sufficient to equate surplus to capital paid in. As a result, as capital of member banks

grows through time, capital paid in grows in proportion. Because surplus is set equal to capital

paid in, it likewise grows at the same rate as member bank capital.

One liability item is distinct from the others. As noted above, the Federal Reserve remits all net

income, after expenses and dividends and allowing for surplus to be equated to capital paid in,

to the U.S. Treasury. As those earnings accrue, they are recorded on the Federal Reserve’s

balance sheet as “Interest on Federal Reserve notes due to U.S. Treasury.” In the event that

earnings only equal the amount necessary to cover operating costs, pay dividends, and equate

surplus to capital paid‐in, this liability item would fall to zero because there are no earnings to

remit and the payment to the Treasury would be suspended. If earnings are insufficient to

cover these costs – that is, there is an operating loss in some period – then no remittance is

made until earnings, through time, have been sufficient to cover that loss. The value of the

earnings that would need to be retained to cover this loss is called a “deferred asset” and is

booked as a negative liability on the Federal Reserve’s balance sheet under the line item

“Interest on Federal Reserve notes due to the U.S. Treasury.”

One consequence of the current implementation of Federal Reserve Bank accounting policy is

that the recording of a deferred asset implies that Reserve Bank capital does not decline in the

event of an operating loss. From time to time, individual Reserve Banks have reported a

deferred asset; however, these deferred assets were generally short‐lived.17 It has never been

the case that the Federal Reserve System as a whole has suspended remittances to the

Treasury for a meaningful period of time because of operating losses.

2.1.8 Other liabilities

The Federal Reserve acts as fiscal agent for the U.S. Treasury. The Treasury holds two accounts

at the Federal Reserve, which are the Treasury’s General Account (TGA) and the Supplemental

17 For example, as shown on the H.4.1 Statistic Release from November 3, 2011, the Federal Reserve Bank of New York recorded a large enough deferred asset so that the Federal Reserve System also did.

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Financing Account (SFA).18 The TGA is the primary account through which the Treasury’s

transactions settle. Major outlays of the U.S. Treasury are generally made from this account

and tax receipts are deposited in this account. The TGA is also used to collect funds from sales

of Treasury debt. Prior to the financial crisis, the Treasury managed the balance in this account,

which receives no interest, to a level of about $5 billion each day, and invested any additional

funds in the banking system. The Treasury traditionally received the federal funds rate less a

spread on funds it had invested in depository institutions. Since late 2008, the federal funds

rate has been close to zero, and the Treasury has placed essentially all of its operating cash in

the TGA.19

The SFA was established by the Treasury in September 2008 to hold the proceeds of the

Supplementary Financing Program and to coordinate with the Federal Reserve in the

management of the aggregate quantity of reserve balances. Under this program, the Treasury

issues marketable debt and deposits the proceeds in an account at the Federal Reserve that is

segregated from the TGA. On a number of occasions as the statutory debt limit appeared to be

binding, the Treasury reduced the quantity of debt issued under the SFP, thereby reducing the

balance in the SFA. The SFA fell to zero in late July 2011 and has stayed at that level

subsequently.

There are a set of other liabilities that we do not discuss in detail because they are, in general,

either small or not particularly relevant for the purposes of these projections. More discussion

of the Federal Reserve’s balance sheet is available on the Board of Governors’ website.20

2.2 Valuation of the SOMA portfolio

There are a number of different ways to record the value of the SOMA portfolio. Reserve Bank

accounting records the SOMA portfolio at par value. The par value of the portfolio, reported in

line 1 of Table 2, gives the face value of the securities in the portfolio. This is the value of the

18 Technically, the Treasury has a general account at each Reserve Bank, however in practice these accounts are consolidated each night into the general account at the Federal Reserve Bank of New York. 19 See http://www.fms.treas.gov/tip/communication/special‐communication‐2008.pdf for the Treasury’s announcement of the suspension of its Term Investment Option auctions. 20 http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm

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portfolio reported in the weekly H.4.1 statistical release. The amortized cost of the portfolio,

also called the book value of the portfolio and shown in line 3, is the par value of the portfolio

plus any unamortized net premiums associated with the securities. A third valuation of the

portfolio is the market value, line 4. The Monthly Report on Credit and Liquidity Programs and

the Balance Sheet and the Annual Report also report the fair value of the portfolio.21 As

interest rates change, the market value of the securities in the portfolio changes. The

difference between the market value and the book value is the unrealized net gain (or loss)

position of the portfolio, line 5. As of the end of March 2012, the portfolio had an unrealized

gain of $177 billion, reflecting a gain on each of the three types of securities holdings.22 March

2012 is the last published information on the position of the portfolio as of the writing of this

paper; however, a similar calculation is possible at roughly any time. In particular, the Federal

Reserve Bank of New York publishes the CUSIP of every security held in the SOMA portfolio.

Combining these CUSIPs with market prices for the securities allows for the calculation—on any

day—of the market value of the Federal Reserve’s portfolio.23

Table 2: Value of the SOMA portfolio as of March 31, 2012 ($ billions)

Treasuries Agency Debt Agency MBS Total SOMA

1. Par value* 1,665 96 837 2,598

2. Net premiums 99 4 12 115

3. Amortized cost 1,764 100 849 2,713

4. Market value 1,892 106 892 2,890

5. Gain/Loss 128 6 43 177

21 The quarter‐end market value of the SOMA portfolio is published in the Monthly Report on Credit and Liquidity Programs and the Balance Sheet, available at http://www.federalreserve.gov/monetarypolicy/clbsreports.htm, with a lag. Alternatively, the Federal Reserve Bank of New York publishes the CUSIPs of all of the securities in the Federal Reserve’s portfolio. Matching these CUSIPs with current market prices allows for an estimate of the current market value of the portfolio. 22 Importantly, even if the SOMA portfolio was in an unrealized net loss position, the ability of the Federal Reserve to implement monetary policy would not be hampered. 23 In addition, the amortized cost of the portfolio is required. In real time, amortized cost can be easily approximated by the par value of the portfolio, which is published weekly, and the net unamortized premiums, which are included in the weekly publication of the balance sheet and are explicitly published quarterly.

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*Par value as of March 28, 2012 from the H.4.1 Statistical Release. Source: Monthly Report on Credit and Liquidity Programs and the Balance Sheet, June 2012.

3 Projections assumptions

In order to construct projections of the Federal Reserve’s balance sheet, assumptions about

many of the details of the balance sheet and its evolution must be made. The following

subsections review assumptions made about key line items of the balance sheet. A detailed

description of these and additional line items is found in Appendix 1.

3.1 Interest rate assumptions

To evaluate the current and future value of securities, and therefore the SOMA portfolio,

assumptions must be made about the path of interest rates over the projection period. For this

analysis, we rely on interest rate projections from the June 2012 Blue Chip forecast for the

federal funds and 10‐year Treasury interest rates. The results of the simulations presented in

this paper would be different under alternative assumed paths for market interest rates. The

assumed path for the federal funds rate and the yield on the 10‐year Treasury note are shown

in Figure 4. The federal funds rate remains in the 0 to ¼ percent range until the end of 2013.

This forecast is the mean of the Blue Chip’s professional forecasters’ responses, and the

forecast does not represent the views of the Federal Reserve or its staff.24 After that point,

interest rates are projected to rise and at the end of the projection period in 2020, the funds

rate stands at 3.6 percent. The yield on the ten‐year Treasury note also rises, from its current

low level of 1.96 percent to 4.9 percent at the end of the projection period.

To perform the asset valuations that will be required, however, an entire yield curve is needed.

As a result, we create a yield curve at each point in time over the projection period using

historical relationships between the federal funds rate, the 10‐year Treasury rate and selected

intermediate tenors. Asset valuation is needed, for example, to project the effect on reserves

of selling MBS as envisioned in the FOMC’s exit principles. The higher the market value of the

24 The January through August 2012 FOMC statements indicated that the federal funds rate would remain at exceptionally low levels “at least through late 2014.” Later in the paper, we provide an alternative scenario where the federal funds rate does not rise above ¼ percent until October 2014.

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security, the more reserves would be drained through the sale. The lower the market value,

the reverse would be true. More details are provided in Appendix 2.

3.2 Nearterm balance sheet assumptions

This subsection reviews our projection methodology for selected asset and liability items that

are of particular interest. All elements of the balance sheet are projected, but we leave those

of less interest to Appendix 1.

3.2.1 SOMA portfolio

The evolution of the SOMA portfolio is intended to be consistent with the FOMC statement on

June 20, 2012. In particular, we assume

(1) The maturity extension program (MEP), which started in September 2011, is continued

through the end of 2012. We assume that the Desk conducts sales of shorter‐dated

Treasury securities so that sales and redemptions total about $44 billion on average per

month and purchases of longer‐term Treasury securities of a similar amount in the

secondary market through the end of 2012; and

(2) Reinvestment of principal payments from agency securities into agency MBS continues

in the near term.

By “near‐term,” we mean the period of time between now and the beginning of an exit strategy

from the current accommodative monetary policy stance.25 Given the initial composition of the

SOMA portfolio on May 30, 2012, the portfolio evolves over time. We adjust the maturity

structure of holdings of Treasury securities and agency securities through time to reflect the

sales and purchases of the MEP along with the reinvestment policy and the passage of time.

Moreover, the forecast for future purchases imposes the constraint that SOMA holdings of any

one CUSIP remain below 70 percent of the total amount outstanding in that CUSIP, as

announced by the Federal Reserve Bank of New York.

Similar to the use of Blue Chip projections for interest rates, we turn to public projections for

the Treasury’s issuance of marketable debt. We use projections of both the amount and the

25 The exit strategy and other timing issues will be discussed in further detail in Section 3.3.

15

maturity of Treasury issuance in order to project securities available for purchase by the Federal

Reserve. We use Treasury issuance as of May 2012, and from that point forward, coupled with

the Congressional Budget Office’s January 2012 projections for total Treasury debt outstanding,

we generate the level and maturity structure of marketable debt outstanding. In addition, we

assume that the average maturity of Treasury debt outstanding extends from its current level

of 62 months to 70 months by 2015, consistent with the Treasury’s stated intentions as of

November 2011.26 Therefore, future Treasury purchases are associated with coupons that

evolve over time reflecting projections in interest rates, Treasury issuance, and the 70 percent

ownership rule.

As noted above, Federal Reserve accounting records the securities holdings at face value and

records any unamortized premium or discount in the “other assets” category. Consequently,

we must project both the face value of the portfolio and the associated premiums. To project

premiums on future securities purchases we need to calculate the market value of securities in

the future. We take the market value for securities as the present discounted cash flow of

these securities using the coupon rate to generate cash flows and the yield curves described in

Section 3.1 and Appendix 2 to discount these cash flows. The premium is the difference

between the face value and the market value of the security. Treasury securities that are rolled

over at auction are assumed to be purchased at par, and therefore have no premium.

For MBS reinvestment, we need to project the coupon of the securities that will be purchased.

The model used for that is described in Appendix 2. Because reinvestments are assumed to

continue only in the near term, we assume that purchases of MBS take place at a price 4

percent above face value, consistent with recent MBS reinvestment activity.

3.2.2 Liabilities and capital

In our modeling, two liability items are important exogenous drivers of the balance sheet

contour – FR notes and the TGA. For simplicity, we assume that FR notes grow in line with the

26 Refer to Minutes of the Meeting of the Treasury Borrowing Advisory Committee the Securities Industry and

Financial Markets Association November 1, 2011, available at http://www.treasury.gov/press‐center/press‐releases/Pages/tg1349.aspx.

16

Blue Chip forecast for nominal GDP. Prior to 2008, the level of the TGA was fairly constant near

$5 billion.27 Since that time, however, the Treasury has maintained essentially its entire cash

balance in the TGA and the TGA has been volatile, reflecting the ebbs and flows of the

Treasury’s cash management as borrowing and tax receipts increase the cash balance and

various outflows reduce the cash balance.28 For the projections, we assume that the TGA

follows the recent historical pattern in the near term, and then drops to $5 billion after the lift

off of the federal funds rate. Capital paid in is assumed to grow at its decade average of 15

percent per year, and surplus is equated to capital paid in. This growth rate plays a role in the

long‐run trend growth rate of the SOMA portfolio.

Reserve balances, an important liability item for the Federal Reserve, are in general calculated

as the residual of assets less other liabilities less capital in the balance sheet projections.

However, we assume a minimum level of $25 billion is set for reserve balances. That level is

roughly consistent with the level of reserve balances observed prior to the financial crisis. Both

FR Notes and capital are trending higher in these projections. To maintain reserve balances at

$25 billion, we assume that the Desk begins to purchase Treasury bills. Purchases of bills

continue until these securities comprise one‐third of the Federal Reserve’s total Treasury

security holdings – as noted above, about the average proportion of Treasury holdings prior to

the crisis. Once this proportion of bills is reached, we assume that the Desk buys coupon

securities in addition to bills to maintain an approximate composition of the portfolio of one‐

third bills and two‐thirds coupon securities.

3.3 Exit strategy assumptions for the balance sheet

For the near‐term projections, we assume that the FOMC completes the continuation of the

MEP policy announced in June 2012. Further out in the projection period, we base our

projections on the general principles for the exit strategy that the FOMC outlined in the

27 For a discussion of Treasury cash management during this period, refer to Garbade, Partlan and Santoro (2004). 28 Refer to FRBNY (2011), pages 28‐29.

17

minutes of the June 2011 FOMC meeting.29 The Committee stated that it intended to take the

following steps in the following order:

(1) Cease reinvesting some or all payments of principal on the securities holdings in the

SOMA;

(2) Modify forward guidance on the path of the federal funds rate and initiate temporary

reserve‐draining operations aimed at supporting the implementation of an increase in

the federal funds rate when appropriate;

(3) Raise the target federal funds rate;

(4) Sell agency securities over a period of three to five years; and

(5) Once sales begin, normalize the size of the balance sheet over two to three years.

To complete the projections, however, we need to make additional assumptions. We tie

changes in the SOMA portfolio to the date the federal funds rises from its effective lower

bound, based on the Blue Chip forecasts. We assume that the reinvestment of securities ends

six months before this date. We do not explicitly model the use of reserve‐draining tools.30 We

assume that sales of agency securities begin six months after the federal funds rate begins to

rise and that the balance sheet has returned to normal size over about three years. In

interpreting “normal size” we rely on the $25 billion minimum level for reserve balances as

“normal.” We summarize the assumed exit strategy in Table 3.31

29 Minutes of the Federal Open Market Committee, June 21‐22, 2011, available at http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20110622.pdf. 30 If term deposits or reverse repurchase agreements were used to drain reserves prior to raising the federal funds rate, the composition of liabilities would change: Reserve balances would fall as term deposits and reverse repurchase agreements rose. Presumably, these draining tools would be wound down as the balance sheet returned to its steady state growth path, so that the projected path for SOMA holdings presented here remains valid. 31 If the expected date of the federal funds lift off is later than in the June 2012 Blue Chip forecast, the start dates for the exit strategy principles will similarly be delayed but the contours of the projections presented here will be roughly unchanged.

18

Table 3 – Key assumptions used in balance sheet projections

Assumption Baseline Later liftoff Faster sales

MEP Treasury Purchases

Amount $667 billion $667 billion $667 billion

Length 15 months 15 months 15 months

First month Oct‐11 Oct‐11 Oct‐11

Last month Dec‐12 Dec‐12 Dec‐12

MEP Treasury Sales or Redemptions

Amount $667 billion $667 billion $667 billion

Length 15 months 15 months 15 months

First month Oct‐11 Oct‐11 Oct‐11

Last month Dec‐12 Dec‐12 Dec‐12

Current Portfolio Strategy

Agency reinvestments Agency MBS Agency MBS Agency MBS

Exit Strategy

Fed Funds liftoff Dec‐13 Oct‐14 Dec‐13

Redemptions start Jun‐13 Jun‐14 Jun‐13

Agency sales

Sales start Jun‐14 Jun‐15 Jun‐14

Sales end May‐18 May‐19 May‐17

Other line items on the balance sheet continue on their projected path as noted above.

4 Projections

In this section, we begin with the baseline projection of the Federal Reserve’s balance sheet.

The baseline scenario provides a useful guide to how the Federal Reserve’s balance sheet might

evolve under reasonable assumptions. Next, we examine two other scenarios that vary some

key assumptions of the projections. In the first, the liftoff of the federal funds rate is delayed

until late 2014, the date referenced in the January 2012 FOMC statement. In the second, the

Committee chooses a more aggressive pace for normalizing the size of the SOMA portfolio and

sells MBS securities over three years. We stress again that these projections are the result of

the underlying assumptions made about interest rates and policy decisions and, as a result, are

not forecasts themselves. The point of the analysis here is to establish a framework for such

projections, and different assumption would, in general, result in different projections.

19

4.1 Baseline

Figures 5 and 6 present the projections of key balance sheet line items under our baseline

scenario. As shown in the top left panel of Figure 5, SOMA holdings (the solid line) remain

roughly at their current level of $2.6 trillion through mid 2013; the MEP and the agency

securities reinvestment policy imply that the size of the SOMA portfolio does not change over

that time period. After that time, under the assumption that the FOMC begins to allow all asset

holdings to roll off the portfolio as the first step in the exit strategy, whose timing is implied by

the interest rate projections, SOMA holdings begin to decline. Notice that SOMA Treasury

holdings, the top right panel, remain constant even when roll off begins. This fact is a result of

the MEP reducing holdings of shorter‐dated Treasury securities to near zero. MBS holdings, the

bottom left panel, on the other hand, begin to contract. Beginning in June 2014, again

consistent with our assumptions about the exit strategy, MBS sales begin, and these holdings

fall to zero by May 2018. On balance, these actions normalize the size of the balance sheet in

2017, four years after MBS sales begin.

The reduction in the size of the SOMA portfolio, along with the projected growth of Reserve

Bank capital and FR notes, results in declines in the level of reserve balances, shown in the

bottom right panel of Figure 6. As described above, we assume that reserve balances are not

allowed to fall below $25 billion. Therefore, in 2017, these projections assume that the Desk

again starts to reinvest maturing Treasury securities and begins purchases of Treasury

securities. After this point in time, the SOMA portfolio expands in line with FR notes and capital

and reserve balances remain constant.

It is in 2017, when the balance sheet is normalized, that the Federal Reserve’s excess securities

holdings drop to zero. That is, private holdings of securities are back to normal and indicate

that market participants believe it is about four years from now when unconventional

monetary policy has essentially unwound.

4.2 Later liftoff

As shown in Figure 4, under the later liftoff scenario (the long dashed line), the federal funds

rate rises above the effective lower bound in October 2014 – one of many possible

20

interpretations of the date referenced in the January through August 2012 FOMC statements

that stated economic conditions are likely to warrant exceptionally low levels for the federal

funds rate at least through late 2014. We stress, however, that this assumption, like all others,

is to some degree arbitrary and could be adjusted. We leave the path of the yield of the 10‐

year Treasury note unchanged for simplicity.

The change in the timing of liftoff in this scenario affects the timing of the exit strategy, and as a

result, the contours of the balance sheet and income. The portfolio stays roughly constant until

mid‐2014, and, as seen in Figures 5 and 6, total SOMA holdings and reserve balances remain in

line with the baseline in the near term. As the assumed date of liftoff approaches and

securities are allowed to mature or are sold, the SOMA portfolio normalizes in size a little less

than one half year later than in the baseline, in early 2018. Sales of MBS continue through early

2019, and the composition of the balance sheet normalizes around that time as well.

This scenario highlights that this later lift off delays the exit of accommodative policy by 11

months relative to the baseline. Hence if market participants shift their view of exit toward the

guidance provided in the January 2012 statement that “economic conditions … are likely to

warrant exceptionally low levels for the federal funds rate at least through late 2014”, such a

shift would imply that the portfolio is expected to remain large for a longer period, and as a

result keep longer‐term interest rates depressed a touch longer than what is expected in the

baseline case.

4.3 Faster sales

The Committee has stated that it ultimately intends to return the SOMA portfolio to holding

only Treasury securities. We assume in the baseline that the sale of MBS takes place over four

years, but the pace could be faster. For this scenario, we assume that the federal funds rate

rises above the effective lower bound at the same time as under the baseline, but that sales of

MBS take place over three years instead of four years. All other assumptions are unchanged

21

from the baseline.32 As shown in Figure 5, the faster sales imply that the size of the SOMA

portfolio returns to normal five months earlier than the baseline scenario, in March 2017. In

addition, as shown in Figure 6, the level of reserve balances contracts somewhat faster than

under the baseline during the sales of MBS.

Compared to the baseline, accommodation will be removed faster in the medium term. So,

longer‐term interest rates will move up a bit faster than in the baseline as well.

5 Conclusion

In this paper we have outlined the mechanics of the Federal Reserve’s balance sheet and how

assumptions about monetary policy affect the outlook for the balance sheet through time.

Under the baseline projections, derived from publicly available forecasts about the economy

and public statements by the FOMC, the balance sheet remains constant for a couple of years

before contracting gradually, and only returning to its long‐run growth path in mid‐ 2017. This

result, if it is expected by market participants and were to be realized in practice, would imply

that unconventional monetary policy actions would be holding interest rates down, to some

degree, for a number of years.

To demonstrate the sensitivity of such projections to alternative assumptions, and to

underscore the fact that these projections are not forecasts per se, but rather, the result of a

set of assumptions, we provided alternative scenarios. These projections provide some

guidance into how alternative assumptions about the removal of unconventional monetary

policy would affect the Federal Reserve’s balance sheet and, hence, longer‐term interest rates.

32 Presumably, selling MBS at a faster rate would tend to increase interest rates relative to the baseline, as the private sector would need to be compensated for holding additional interest rate risk. We do not model this effect in our projections, but it would likely cause realized losses on sales to be slightly higher than modeled here.

22

6 Bibliography

Board of Governors of the Federal Reserve System. 1976. Banking and Monetary Statistics,

1914‐1941.

Chung, Hess, Laforte, Jean‐Philippe, Reifschneider, David, and Williams, John C. 2011. “Have

We Underestimated the Likelihood and Severity of Zero Lower Bound Events?” Federal Reserve

Bank of San Francisco Working Paper 2011‐01, January.

Edwards, Cheryl E. 1997. “Open Market Operations in the 1990s,” Federal Reserve Bulletin, p.

859‐874.

Federal Reserve Bank of New York. 2011. “Domestic Open Market Operations in 2010,”

available for download at

http://www.newyorkfed.org/markets/Domestic_OMO_2010_FINAL.pdf

Garbade, Kenneth D., Partlan, John C., and Santoro, Paul J. 2004. “Recent Innovations in

Treasury Cash Management,” Current Issues in Economics and Finance, Federal Reserve Bank of

New York, vol. 10, no. 11, November.

Gurkayank, Refet, Sack, Brian, and Wright, Jonathan. 2007. “The U.S. Treasury yield curve:

1961 to the present,” Journal of Monetary Economics, p. 2291‐2304, November.

Ihrig, Jane, Klee, Elizabeth, Li, Canlin, Schulte, Brett, and Wei, Min. 2012. “Expectations about

the Federal Reserve’s Balance Sheet and the Term Structure of Interest Rates,” forthcoming

Federal Reserve Finance and Economics Discussion Series paper.

Judson, Ruth, and Porter, Richard. 1996. “The Location of U.S. Currency: How Much is

Abroad?”, Federal Reserve Bulletin, vol. 82, p. 883‐903, October.

Meltzer, Allan. 2010. A History of the Federal Reserve, Volume 2, 1951‐1986, University of

Chicago Press.

23

Rudebusch, Glenn D. 2011. “The Fed’s Interest Rate Risk,” Economic Letters, Federal Reserve

Bank of San Francisco, April 11.Yellen , Janet. “Perspectives on Monetary Policy,” speech at the

Boston Economic Club Dinner, Boston, Massachusetts, June 6, 2012.

24

Appendix 1: Overview of assumptions underlying the Balance Sheet projections

This appendix provides details about the forecasting procedure for each balance sheet item.

Those not specifically discussed are held at their level as of May 31, 2012.

6.1 Treasury securities

SOMA Treasury holdings are assumed to evolve through a combination of outright purchases

and outright sales in the secondary market, reinvestment at auction, and maturities.

Outright purchases for the $667 billion Maturity Extension Program (MEP) are simulated

according to the maturity buckets and targets as announced by the Federal Reserve

Bank of New York:

Maturity Extension Program purchase distribution (percent)

Nominal coupon securities TIPS

6‐8 years 8‐10 years

10‐20 years

20‐30 years

32 32 4 29 3

Securities assumed to be available for purchase reflect those outstanding on the

Monthly Statement of the Public Debt as of May 31, 2012 as well as forecasts for future

issuance. Holdings of any particular CUSIP are limited to 70 percent of the CUSIP

outstanding, consistent with the Desk’s current practice.

Sales and maturities associated with the MEP will take place in Treasury securities with

remaining maturities of up to three years.

The total par value of Treasury securities outstanding reflects the Congressional Budget

Office’s (CBO) projections for total debt held by the public.

The average maturity of Treasury debt extends from its current value of 60 months to

70 months, consistent with observations made by the Treasury Borrowing Advisory

Committee in November 2011.33

The proceeds from maturing securities are reinvested at auction at rates consistent with

the Blue Chip forecast for interest rates, as discussed in Appendix 2. Auction sizes are

determined by the amount of total debt necessary to match CBO projections and follow

33 Refer to http://www.treasury.gov/press‐center/press‐releases/Pages/tg1349.aspx.

25

a distribution determined by actual auctions through May 2012. This distribution is then

altered as necessary to extend the average maturity of Treasury debt. The CBOs debt

projections along with the maturity distribution of securities auctioned in November

2011 are summarized in the tables below.

Year

CBO debt held by

the public ($ Billion)

Buckets

May 2012 Issuance by bucket ($ Billion)

Initial shares of issuance

2010 9,019 1 month 120 0.22

2011 10,128 3 month 120 0.22

2012 11,242 6 month 108 0.2

2013 11,945 1 year 25 0.05

2014 12,401 2 year 35 0.07

2015 12,783 3 year 32 0.06

2016 13,188 5 year 35 0.07

2017 13,509 7 year 29 0.05

2018 13,801 10 year 21 0.04

2019 14,148 30 year 13 0.02

2020 14,512 Source: Wrightson, Auction Calendar

2021 14,872 Source: CBO, Jan. 2012 “The Budget and Economic Outlook: Fiscal Years 2012 to 2022”

The agency securities portfolio is assumed to evolve due to a combination of purchases, sales,

and prepayments.

Consistent with the FOMC’s statement after the September 2011 FOMC meeting,

principal payments from SOMA agency MBS and debt and are reinvested in agency MBS.

We use a current coupon model to estimate the coupon on newly purchased MBS

securities based on the consensus long‐run Blue Chip forecast for the 10‐year Treasury

rate, reviewed in Appendix 2.

Prepayments on settled agency MBS holdings as of May 31, 2012 are generated by

applying the realized prepayment rate on the SOMA holdings of MBS from June 2010 to

July 2011 (the period when there were no new holdings of MBS settling in the SOMA

portfolio) on monthly holdings from June 2012 to the federal funds liftoff, in December

2013. This prepayment rate is notably faster than what would be predicted using the

standard PSA prepayment model, likely a result of the historically low level of mortgage

26

rates. After the federal funds rate lifts off, we gradually smooth the prepayment rate

back to the long‐run PSA model over a five year period.

Prepayments on anticipated future purchases of agency MBS follow the long‐run PSA

model for the life of the security.

Sales of agency securities begin six months after the first increase in the federal funds

rate and last for four years. This timing is consistent with that laid out in the June 2011

FOMC Minutes; however, the exact timing is merely illustrative and chosen so as to be

easily implementable in our projections.

Under these assumptions, and given the maturity schedule for agency debt securities,

the volume of sales necessary to reduce holdings of these securities to zero over the

four year period only requires a six month period of minimal sales near the end of those

four years.

6.1.1 Premiums and discounts

A premium (discount) is the amount paid above (below) the par value of a security. As of

March 31, 2012, the Federal Reserve had $99 billion in net unamortized premiums on Treasury

securities, $4 billion on agency debt securities, and $12 billion on agency MBS. We use straight‐

line amortization of these premiums and discounts over the expected life of current SOMA

holdings. We derive new premiums and discounts from outright Treasury purchases by using

the difference between the assumed coupon of the security being purchased and the

corresponding market interest rate, as given by the yield curve estimates reviewed in Appendix

2. We assume that agency MBS are purchased at a price 4 percent above par value, and

therefore book some premiums on these asset purchases. Based on the calculations for the

purchase prices of Treasury securities, we estimate that there are approximately $60 billion in

premiums associated with Treasury securities purchases over the course of the Maturity

Extension Program.

6.1.2 Discount window lending

We make the simplifying assumption that all discount window lending over the projection

period is zero.

27

6.1.3 TALF LLC

Assets held by TALF LLC consist of investments of commitment fees collected by the LLC and the

U.S. Treasury’s initial funding. In this projection, the LLC does not purchase any asset‐backed

securities received by the Federal Reserve Bank of New York in connection with a decision of a

borrower not to repay a TALF loan. The assets held by TALF LLC remain at their current level of

about $1.0 billion through 2014 before declining to zero the following year.

6.1.4 Maiden Lane, Maiden Lane II, and Maiden Lane III

The assets held by Maiden Lane LLC, Maiden Lane II LLC and Maiden Lane III LLC decline

gradually over time reflecting known sales in the near term and a slow drop to zero thereafter.

Holdings for all three LLCs fall to zero by early 2015.

6.1.5 Reserve balances

Reserve balances are the residual of assets less other liabilities less capital in the balance sheet

projection. That said, a minimum level of $25 billion is set for reserve balances, roughly

equivalent to the level of reserve balances before the start of the financial crisis. To maintain

reserve balances at this level, first Treasury bills are purchased. Purchases of bills continue until

these securities comprise one‐third of the Federal Reserve’s total Treasury security holdings–

about the average level prior to the crisis. Once this level is reached, the Federal Reserve buys

notes and bonds in addition to bills to maintain an approximate composition of the portfolio of

one‐third bills and two‐thirds coupon securities. In general, increases in the level of Federal

Reserve assets add reserve balances. By contrast, increases in the levels of liability items, such

as Federal Reserve notes in circulation or other liabilities, or increases in the level of Reserve

Bank capital, drain reserve balances.

6.1.6 Currency

Federal Reserve notes in circulation are assumed to grow at the same rate as nominal GDP. We

use the consensus Blue Chip forecasts for real GDP growth and the price level to form the

forecast for nominal GDP through September 2013. Because this is an annual forecast, we use

28

the annual growth rate as the annualized quarterly growth rate for the 2nd and 3rd quarters of

each year, and then interpolate growth rates for the 1st and 4th quarters of the year. The table

below summarizes the Blue Chip projections for nominal GDP growth.

Year

Blue Chip nominal GDP

growth forecast

2012 4.4%

2013 4.8%

2014 5.0%

2015 5.2%

2016 5.1%

2017 5.0%

2018 4.9%

2019 4.6%

2020 4.6%

Source: Blue Chip, June 2012

6.1.7 Reverse Repurchase Agreements (RRPs)

The Federal Reserve conducts RRPs with foreign official accounts, international accounts, and

other counterparties. The volume of RRPs that is conducted with foreign official and

international accounts is assumed to stay constant at its most recent level of approximately $98

billion in May 2012. The portion that is conducted with others is assumed to stay at zero over

the projection period.

6.1.8 U.S. Treasury’s General Account (TGA)

The TGA cash balance is projected to follow the recent historical pattern in the near term, and

then drops to $5 billion after the lift off of the federal funds rate.

29

6.1.9 Supplementary Financing Account (SFA)

We maintain the SFA balance at its current level of zero throughout the forecast, consistent

with the Treasury Borrowing Advisory Committee’s recommendation not to resume the

program at this time.34

6.1.10 Capital

Federal Reserve capital grows 15 percent per year, in line with the average rate of the past ten

years.

6.1.11 Deferred Asset

In the event that a Federal Reserve Bank’s earnings fall short of the amount necessary to cover

operating costs, pay dividends, and equate surplus to capital paid‐in, a deferred asset will be

recorded. This deferred asset is recorded in lieu of reducing the Reserve Bank’s capital and is

found on the liability side of the balance sheet as “Interest on Federal Reserve notes due to U.S.

Treasury.” This liability takes on a positive value when weekly cumulative earnings have not yet

been distributed to the Treasury, while this liability takes on a negative value when earnings fall

short of the expenses listed above.

34 Refer to “Minutes of the Meeting of the Treasury Borrowing Advisory Committee, the Securities Industry and Financial Markets Association, November 1, 2011,” available for download at http://www.treasury.gov/press‐center/press‐releases/Pages/tg1349.aspx.

30

Appendix 2: Constructing yield curves and coupons on purchased securities and valuation of the SOMA portfolio35

The projections for the coupon rates on Treasury securities depend on forecasts for the yield

curve. We construct a zero‐coupon yield curve using projections for the federal funds rate and

the forecast for the 10‐year Treasury yield, where these independent variables are taken from

the June 2012 Blue Chip forecast for future interest rates.

We specify the relationship between a yield at tenor i and these rates using a regression:

1 2 (10 )it i i t i t ity ff year ,

where yit is the zero‐coupon yield for maturity i at time t, α is a constant term, β1i is the yield‐

specific coefficient on the federal funds rate, β2i is the yield‐specific coefficient on the 10‐year

rate, and εit is an error term. We evaluate this specification on historical data at the 2, 3, 4, 5,

10, 15, 20, and 30 year tenors. The historical data are yields constructed from an off‐the‐run

Svensson‐Nelson‐Siegel zero‐coupon yield curve, the Treasury yield curve used in production

work at the Board.36 The sample is daily data from January 3, 1994 to April 10, 2010. Standard

errors are calculated using a robust sandwich procedure.

The estimated coefficients and associated R‐squared statistics are displayed in the appendix

table A2‐1. In general, the results are in line with intuition and these two rates can explain

almost all the variation in the other rates. In addition, we performed a series of robustness

checks. Specifically, longer‐term rates tended to exhibit cointegration with the 10 year rate,

but shorter‐term rates did not. Overall, the estimated coefficients and resulting yield curves

presented here are broadly similar to those using a cointegrated or other type of specification.

With these estimates in hand, we then construct “initial” yield curves for each point in time in

our forecast, interpolating values for tenors for which we do not explicitly estimate a model.

We use these for our projected coupons on Treasury securities we purchase over the forecast

period.

35Much of the methodology described in this section is attributable to Viktors Stebunovs and Ari Morse. 36 For details, refer to Gurkaynak, Sack and Wright (2007).

31

An additional estimate is needed to forecast the coupon rate on future MBS purchases. This is

done by estimating the statistical relationship between the Fannie Mae MBS current coupon

rate and the 10‐year Treasury rate. We use quarterly averages of daily data from 1984Q4 to

2011Q3 to generate our parameter estimates. We use an ARIMA(1,1,0) model to account for

the autocorrelation in the error terms and the cointegration in the two series. As is evident

from table A2‐2, changes in the 10‐year rate are matched almost one‐to‐one with those in the

MBS current coupon rate, and the autocorrelation in the differenced series, while not strong, is

still persistent enough to be relevant in tests for autocorrelation of the residuals.

32

Table A2‐1: Yield curve regressions

Effective rate 10‐year rate Constant

R‐squared

Year Coefficient Standard

error T‐stat Coefficient

Standard

error T‐stat Coefficient

Standard

error T‐stat

2 0.536*** 0.003 155.438 0.746*** 0.007 109.305 ‐0.018*** 0 ‐62.483 0.971

3 0.392*** 0.003 131.062 0.877*** 0.006 154.592 ‐0.018*** 0 ‐72.969 0.975

4 0.282*** 0.002 116.573 0.945*** 0.004 211.367 ‐0.015*** 0 ‐80.671 0.982

5 0.196*** 0.002 107.059 0.980*** 0.003 293.544 ‐0.012*** 0 ‐87.013 0.988

7 0.071*** 0.001 87.829 1.003*** 0.001 678.057 ‐0.006*** 0 ‐95.999 0.997

10 ‐0.039*** 0 ‐119.39 1.000*** 0.001 1420.984 0.002*** 0 59.475 0.999

15 ‐0.121*** 0.001 ‐88.754 0.995*** 0.003 397.277 0.008*** 0 76.072 0.983

20 ‐0.149*** 0.002 ‐64.611 1.013*** 0.004 269.745 0.010*** 0 54.576 0.953

30 ‐0.168*** 0.004 ‐46.25 1.083*** 0.006 196.249 0.005*** 0 19.391 0.9

N 4067

Sample: 1/3/1994‐4/10/2010

33

Table A2‐2: MBS coupon forecasting regression

Forecasting MBS current coupon

Dependent variable: Δ(Fannie Mae 30‐year

current coupon)

Coefficient

Standard

error Z

Δ(10‐year rate) 0.981 0.031 32.12

AR(1) 0.095 0.069 1.37

Constant ‐0.004 0.017 ‐0.26

N 107

Assets

Liabilities

Support for specific institutions (ML LLCs, Bear, AIG) →

Other credit facilities (PDCF, AMLF, CPFF, TALF) →

Central bank liquidity swaps

Loans (includes term auction credit)

All other assets

Agency debt and MBS holdings

Repurchase agreements

Treasury securities held outright

Federal Reserve notes in circulation

Reverse RPsCapital Other Liabilities−>

U.S. Treasury accounts

Deposits of depository institutions

Other Deposits −>

0

500

1,000

1,500

2,000

2,500

3,000

3,000

2,500

2,000

1,500

1,000

500

$ B

illio

ns

Jan 4, 2006 Jul 5, 2006 Jan 3, 2007 Jul 4, 2007 Jan 2, 2008 Jul 2, 2008 Dec 31, 2008 Jul 1, 2009 Dec 30, 2009 Jun 30, 2010 Dec 29, 2010 Jun 29, 2011 Dec 28, 2011 Jun 27, 2012Wednesdays

Figure 1 − Federal Reserve’s Assets and Liabilities

Last updated July 7, 2012.

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

0

500

1000

1500

2000

2500

3000$Billion

SOMACapital+NotesReserve Balances

Figure 2 - SOMA, Capital + FR Notes, and Reserve Balances

Source: H.4.1 Statistical Release

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 0

20

40

60

80

100Months

Figure 3 - Weighted Average Maturity of SOMA

Note. Includes only nominal Treasury securitiesSource: Federal Reserve Bank of New York and Center for Research in Security Prices

Figure 4 - Interest Rates*

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

0

1

2

3

4

5

6

7percent

Baseline & Faster SalesLater Lift-off

Federal Funds Rate

Quarterly

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

2

3

4

5

6

7percent

Baseline & Faster SalesLater Lift-off

10 year Treasury Rate

Quarterly

* Baseline interest rate paths are the consensus June 2012 Blue Chip forecast; later lift off path are authors’ calculations

Figure 5 - Selected Assets Projections

2006 2008 2010 2012 2014 2016 2018 2020

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000Billions of dollars

BaselineLater Lift-offFaster Sales

SOMA Holdings

Monthly

2006 2008 2010 2012 2014 2016 2018 2020

0

500

1000

1500

2000

2500

3000

3500



SOMA Treasury Holdings

Monthly

2006 2008 2010 2012 2014 2016 2018 2020

0

200

400

600

800

1000

1200

1400



SOMA Agency MBS Holdings

Monthly

Source: Authors’ Projections

2006 2008 2010 2012 2014 2016 2018 2020

0

100

200

300

400

500



SOMA Agency Debt Holdings

Monthly

Figure 6 - Selected Liabilities Projections

2006 2008 2010 2012 2014 2016 2018 2020

0

200

400

600

800

1000

1200

1400

1600

1800



FR Notes

Monthly

2006 2008 2010 2012 2014 2016 2018 2020

0

20

40

60

80

100

120

140

160

180

200

220



Treasury General Account

Monthly

2006 2008 2010 2012 2014 2016 2018 2020

0

20

40

60

80

100

120

140

160

180

200



Capital Paid In

Monthly

Source: Authors’ Projections

2006 2008 2010 2012 2014 2016 2018 2020

0

500

1000

1500



Reserve Balances

Monthly

Documents

The Federal Reserve's Balance Sheet: A Primer and Projections